We had so much interest from our “Depreciation in Real Estate & Why You Should Care” article last month that we wanted to use this issue of BENA Capital Insights to address some commonly asked questions that we received!
As we mentioned in our last issue, one of the many advantages to having real estate as part of your investment portfolio is the use of depreciation to lower tax burdens. Depreciation recognizes that buildings and other improvements have a limited useful life. When you do your taxes, the IRS permits property owners to write off the value of an asset and claim tax savings through depreciation deductions.
Here are some great questions we received:
Q: Can you depreciate land?
No. Land cannot be depreciated for tax purposes. When you purchase real estate, the cost is typically allocated between the land and any improvements (ie. buildings). Depreciation only applies to tangible property such as buildings, machinery, equipment, vehicles, furniture, etc. Land is considered a non-depreciable asset because it is not subject to wear and tear over time.
Q: You mentioned that buildings and other improvements have a limited “useful life” - what does that mean?
The useful life of a building, in the context of depreciation, refers to the period over which the cost of the building can be deducted as an expense for tax purposes. It is an estimate of how long the building is expected to remain economically viable or useful for generating income. The IRS sets guidelines for the useful life of different types of property, including buildings. Typically, residential rental properties are depreciated over 27.5 years, while commercial buildings are depreciated over 39 years. These periods are used to calculate annual depreciation deductions. An asset can be depreciated only over this period of time.
Q: What happens when you sell?
One important thing to remember about depreciation is that the IRS taxes that depreciation upon the sale of a property through what is known as depreciation recapture. When you sell the property, any profit from the sale is generally subject to capital gains tax. Capital gains are calculated as the difference between the sale price and the property's adjusted basis (typically the original purchase price plus any improvements).
Depreciation recapture comes into play if the property is sold at a gain and you have previously taken depreciation deductions on it. The IRS requires that a portion of the gain attributable to the depreciation deductions must be "recaptured" and taxed as ordinary income rather than as capital gains.
Depreciation recapture ensures that taxpayers do not indefinitely defer taxes on the income generated by depreciation deductions.
There are many benefits to depreciation including its ability to offset your taxable income; however, it’s important to be aware of depreciation recapture, which makes you responsible for paying the taxes on the depreciation taken over the life of your investment.